Transcript

(00:00): Making markets. When two people place different values on something, they might want to do a trade with each other. We’ll say that two people trade a contract. Here are some examples of contracts.

1. In what year was Mark Twain born?

2. Will the Yankees win the next World Series?

(00:22):
Each contract is a question. When we learn the answer, we give the contract a final value called the settlement price. The first contract above will settle to the year Mark Twain was born or 1835. The second will settle to either zero if the Yankees lose or one, if they win. Note that the settlement price of the first contract is predetermined whereas the settlement price of the second is not.

(00:49):
In the course of trading, you need a way to say what trades you’d be willing to do. For example, suppose we’re trading a stock and you’d be happy to buy 100 shares for $34. You would say 34 bid for 100. How does this encode your message? First the word bid always indicates you’re on the buy side. The word for means the same thing. It’s only used in expressing a desire to buy.

(01:15):
Second, you are giving a price at which you’re willing to buy 34 and a size indicating how many contracts you’d be willing to do, 100. Finally, when showing a bid, you always say the price first and the size second. If you were instead looking to sell 100 shares at $36.80, you would say 100 offered at 36 spot eight. The key differences? The words offered and at are both used only in offers to sell and the size now becomes before the price.

(01:52):
Here’s a quick check. If a trader says 17 bid for 25 in trading some contract, are they trying to buy or sell? At what price and for how many contracts? What if they say 30 at nine? A proper market quotes both a bid, buy side and an offer or ask, sell side using the jargon above. So your market in the stock might be 34 bid for 100, 100 offered at 36 spot eight.

(02:23):
Let’s make a market on the flip of a coin. Contracts will settle to 100 if the flip is heads and zero, if the flip is tails. What’s your market? Since you know the fair value is 50 you might say 45 bid for 10, 10 at 55. If I sell you 10 contracts at your bid of 45, you’ll make $50 in expected value. Take a moment to think about why this is.

(02:50):
If you are more confident in your fair value, you can show a tighter market such as 49 bid for 10, 10 at 51. If you’re uncertain or just don’t like the risk, you might state a wider market, 40 bid for 10, 10 at 60. Or reduce your size, 45 bid for three, three at 55. If you’re willing to trade more on one side of the market perhaps to manage your risk, you might show more size on the bid or offer as in 45 bid for five, 30 at 55.

(03:24):
If your bid size and ask size are the same, you can save time by saying bid price at ask price size up. Expressed this way our market in the stock would be 34 at 36 spot eight, 100 up and our market in the coin would be 45 at 55, 10 up. If you decide you don’t like your quoted market, you can clear your market by saying I’m out before a trade occurs. For example, perhaps you make a market of 34 at 36 spot eight, 100 up in the stock. Then shortly afterwards, see a news report announcing that the stock is performing much better this month than they did last month. Until you clear your market, it’s presumed to be available for others to trade on. No take backs.

(04:13):
Sometimes you might be interested in trading on other people’s markets. To buy all the contracts on the offer say buy them or take them. To sell all the contracts on the bid, say sold. To trade some but not all specify a size as in buy five or sell 10. The best way to become comfortable with market making language is to practice making markets aloud. Here are a few to try, but you should also make up some of your own. The population of New York City, Germany winning the next World Cup. The number of stocks in the FTSE 100.